Which college plan should you tap first?

By: Savingforcollege.com


Dear Joe, I have two daughters, one in 11th grade and one in eighth grade. I have a Uniform Gift to Minors Act account and a 529 for each of them. The UGMA accounts each have about $16,000 in them and I no longer contribute to them. Each 529 has about $13,000 and I am still contributing to them in age-based portfolios. I'm in the 25 percent tax bracket. The girls have no other income. Which one should I tap first to pay for their college expenses? -- David


Dear David,

I suspect you'll be best off by using the UGMA money before tapping your 529 plans. The biggest reason has to do with financial aid: Investment assets in your daughters' names, or in their UGMAs, are counted heavily in determining their expected family contribution, or EFC. Higher EFC means less need-based financial aid.

By spending down those assets before filing the Free Application for Federal Student Aid, or FAFSA, financial aid application, your daughters will have a better chance of receiving government-subsidized loans and work-study.

Another reason to choose the UGMA money first has to do with income taxes. Each of your daughters can report up to $1,800 in investment income this year (2008) using the lowest income-tax brackets. (Unearned income above $1,800 will be subject to the "kiddie tax" and taxed at your 25-percent bracket.)

Even better, the portion of their investment income below $1,800 that consists of long-term capital gains and qualifying dividends will not be taxed at all for federal purposes. The zero-percent bracket for capital gains and dividends is available for the years 2008 through 2010 to all taxpayers who are in the 10-percent or 15-percent ordinary-income brackets.

A reasonable strategy would be to take maximum advantage of your child's low or zero tax brackets each year by triggering gains, as long as the gains are not so high as to incur the kiddie tax. The cash can then be spent on anything that benefits your child, including education.

Or, it can be contributed to a "custodial" account with a 529 plan. Spent assets will not be reported on the FAFSA (obviously) and 529 assets owned by your child will add much less to the EFC than will non-529 investment assets owned by your child or in the UGMA.

Take note, however, of the impact of a child's income on EFC. If your older daughter applies for financial aid next year, this year will be her "base" year for reporting income on the FAFSA. You do not face this problem -- yet -- for your younger daughter.

A 529 plan has an advantage in that the tax-free distributions used to pay for college will not be reported as income on the following year's FAFSA.

Your 529 accounts can be left to grow until your daughters' UGMA money has been fully spent. Money from the 529s can then be withdrawn tax-free for college expenses.

The biggest caveat concerns a situation where you may have more money in 529 plans than needed for your daughters' college expenses. You want to avoid being in the position where your withdrawals from the 529 plans are subject to tax and penalty because you cannot show sufficient qualified education expenses.

In that case, it could make more sense to tap your 529 accounts before using non-529 assets to pay for college.

Popular Questions


Two kids, two 529 plans?

Dear Big Bill,
While it's possible to maintain a 529 plan in just one child's name, even when you intend to send more than one child to college, I generally recommend that families open a separate 529 account for each child.

That's assuming there is no additional cost to maintaining multiple accounts. If your 529 plan charges an annual or quarterly account maintenance fee, check to see if you can avoid the fee by signing up for automatic contributions through payroll deduction or electronic funds transfer)

With a separate 529 plan for each child, it becomes easier for you to tailor the mix of stocks, bonds and stable-principal investments (e.g., stable value, guaranteed principal and money market funds) to the particular ages of your children. When your older child is nearing high school graduation, you may want to ratchet down the level of market risk in her 529 plan. At the same time, you could keep a more-aggressive asset allocation in your younger child's 529 plan, accepting more risk for a potentially higher return. Many 529 plans offer "age-based" investment options that automatically make these adjustments as the beneficiary ages.

Separate accounts for your children also offer more gift-tax leeway. Since your 529 contributions are treated as gifts from you to the account beneficiary, your $15,000 (in 2018) annual gift exclusion will go twice as far with two accounts -- one for each child -- than with just one account.

Financial aid is another reason to recommend maintaining separate accounts. You wouldn't want the investments reserved for your younger child's future college expenses to count against your older child's financial aid eligibility. Be warned: The rules here are rather murky, and the impact of a sibling's 529 account may depend on the college's own policies as well on as the type of aid -- federal or institutional -- being sought.

Finally, I believe that separate 529 accounts allow for better family bookkeeping. There will never be any doubt as to your intention to help send all of your children to college. You'll avoid the uncomfortable position of being asked to explain to a curious 8th-grader why account statements are showing up in the mail with only a brother or sister's name on them. And in the event of your death or divorce, no matter how unlikely, your legal representatives and other family members will have less reason to question your actions in setting up and funding the 529 plans.

Even with separate accounts, you'll continue to have the flexibility to shift the money around in the future. You simply need to make sure that whenever funds are withdrawn from the 529 plan to pay for college they are coming from an account in the name of the child incurring the costs. It's a simple matter to change the beneficiary designation among family members at any time, transfer 529 funds between different family members' accounts or split one 529 account into two. The ability to move assets around the family is a key advantage of 529 plans when comparing other college-savings alternatives, such as Uniform Transfers to Minors Act, or UTMA, accounts.

Original Post: 2005-10-13
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Coverdell ESA vs. 529 Plan: Which to choose? (Script)

The Coverdell ESA and the 529 plan are both excellent college savings vehicles because they are both tax-free when used for college. But many families face a choice: do they use a 529 plan for all of their child's college savings, or do they use a Coverdell for the maximum amount of $2,000 each year and put any any extra savings above $2,000 into a 529 plan? In spite of its low annual contribution cap, Coverdell's are now attracting quite a few families. There are two major reasons for that. One is that only the Coverdell allows you to self-direct your investments, just like you might self-direct the investments in your IRA. The other is that in addition to college expenses, Coverdells can be withdrawn tax-free to pay for a broad range of K-12 expenses, while 529 plans are limited to K-12 tuition. This feature is appreciated most in families planning to send their children to private grade schools, which may include additional costs such as room and board or uniforms. A 529 plan, on the other hand, does not impose age limits or income limits like the Coverdell does and so overall we see a lot more money going into 529 plans than into Coverdells. Plus many savers are happy with the investment choices offered by the 529 plans and don't necessarily want to self-direct their investments. And don’t forget this: your state may be giving you a state tax deduction for using a 529 plan, but there are no states offering a state tax deduction for investing with a Coverdell ESA.

Learn more about Coverdell ESAs.

Original post date 2013-07-15
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Top 529 Plan Withdrawal Tips. (Script)

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Top 529 Plan Withdrawal Tips. (Video)

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